By The Valuentum Team
Xilinx's Investment Considerations
• Xilinx (NASDAQ:XLNX) makes FPGAs, SoCs and 3D ICs. These devices are coupled with a next-generation design environment and IP to serve a broad range of customer needs, from programmable logic to programmable systems integration. The company was founded in 1984 and is headquartered in California.
• As with rival Altera (NASDAQ:ALTR), which was recently acquired by Intel (NASDAQ:INTC), Xilinx's strategy centers on the displacement of ASICs and ASSPs in the development of next-generation electronic systems. The company strives to drive down cost and power consumption at each manufacturing process node.
• Investors in technology pay close attention to a firm's gross margin to get a read for product pricing pressures. Fiscal year 2015 marked a record gross margin of 70% for the company, up a full percentage point from the prior fiscal year. We like the company's focus on growing earnings and its extremely cash-rich balance sheet.
• The company is experiencing solid momentum in the 28nm market. Xilinx's quarterly revenue run-rate is expanding, and the firm ended fiscal 2015 with $580 million in 28nm revenue. Difficult broadcasting and communications end markets may cap firm-wide sales growth, however. Sales are expected to be flat in the March 2016 quarter on a sequential basis.
• Many are speculating that Xilinx will be next to be taken out by a larger partner. Even if this never happens, the company is executing nicely on a standalone basis. Xilinx continues to have nice things to say about new product sales, and its 7-Series and UltraScale families continue to perform well.
• The company is heavily dependent on distributor Avnet (NYSE:AVT) for the majority of sales revenue and order fulfillment. Resale of product through Avnet accounts for 40%+ of worldwide revenue and for two-thirds of total net accounts receivable. We think investors should be aware of this concentration, if only because it is part of the business.
• Free cash flow generation, as measured by cash flow from operations less all capital spending, is by far Xilinx's most attractive attribute. The company spends ~$6-$10 million in capex in any given quarter while it pulls in hundreds of millions in operating cash flow.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Xilinx's 3-year historical return on invested capital (without goodwill) is 121.9%, which is above the estimate of its cost of capital of 10.2%. As such, we assign the firm a ValueCreation™ rating of excellent.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid gray line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Xilinx's dividend cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is strong at 3.1 (anything above 1 is considered strong).
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Xilinx's free cash flow margin has averaged about 30.9% during the past 3 years. As such, we think the firm's cash flow generation is relatively strong.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Xilinx, cash flow from operations increased about 20% from levels registered two years ago, while capital expenditures fell about 2% over the same time period.
In the first 9 months of fiscal 2016, Xilinx reported operating cash flow of ~$607 million and capital expenditures of ~$19 million resulting in free cash flow of ~$588 million, a ~2% decrease from fiscal 2015.
This is the most important section of our analysis. Below, we outline our valuation assumptions and derive our fair value estimate for shares.
Our discounted cash flow model indicates that Xilinx's shares are worth between $35-$53 each. Shares are currently trading at ~$47, in the upper half our fair value range. This indicates that we feel there is slightly more downside risk than upside potential associated with shares at this time. Cash-rich equities sometimes are bid up by the market.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $44 per share represents a price-to-earnings (P/E) ratio of about 18.7 times last year's earnings and an implied EV/EBITDA multiple of about 12.1 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 2.9% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 2%. Our model reflects a 5-year projected average operating margin of 31.3%, which is above Xilinx's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 3.2% for the next 15 years and 3% in perpetuity. For Xilinx, we use a 10.2% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $44 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
In the graph above, we show this probable range of fair values for Xilinx. We think the firm is attractive below $35 per share (the green line) but quite expensive above $53 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Xilinx's fair value at this point in time to be about $44 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Xilinx's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $56 per share in year 3 represents our existing fair value per share of $44 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Wrapping Things Up
Xilinx's focus on driving down cost and power consumption at each manufacturing process node is noteworthy, and the company put its operating prowess on display in fiscal 2015 when it reported a record gross margin of 70% as product pricing pressures let up. The firm ended fiscal 2015 with $580 million in 28nm revenue, compared to $380 million in fiscal 2014, which has helped Xilinx's quarterly revenue run-rate expand. Difficult broadcasting and communications end markets may cap firm-wide sales growth, however. In any case, we're big fans of the company's robust free cash flow generation and cash-rich balance sheet, and Xilinx's dividend cushion ratio of 3.1 suggests the dividend is solid. The firm currently registers a 6 on the Valuentum Buying Index.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.